Chapter 6

Measure Domestic Output, National Income, and the price level

Table 1. GCC Countries: Selected Economic Indicators, 2002

Nominal GDP

(Millions of U.S.

dollars)

Nominal GDP (Per

capita in U.S.

dollars)1 Population (Millions)1

Overall Fiscal

Balance (Percent of GDP)2

Total Government Gross Debt (Percentof

GDP)

Proven Oil

Reserves (Years)3

Central Bank

Foreign Assets

(Months of Imports)4

Current Account Balance

(Percent of GDP)

Country Bahrain 8,506 11,619 0.7 0.8 30.3 15.0 2.7 0.3 Kuwait 33,215 15,098 2.2 20.6 32.9 134.0 10.7 20.9 Oman 20,290 7,515 2.7 3.7 16.0 16.0 4.8 10.0 Qatar 17,321 28,362 0.6 5.1 58.2 15.0 2.7 13.8 Saudi Arabia 188,960 8,567 22.1 –5.3 93.8 85.0 12.9 4.7

U.A.E. 71,187 19,613 3.6 –9.3 4.5 124.0 4.7 5.5 GCC 339,479 11,9795 31.9 –2.75 66.65 83.75 7.6 6.95

National income accounts enable us to:

a. Measure the economy’s overall performance by measuring the flows of income and expenditures over a period of time (Assess the health of the economy)

a. Track the long run course of the economy: growing, declining, or constant (compare conditions over time and across countries)

b. Provide a basis for appropriate public policies to improve economic performance (improve the economy’s health)

Assessing the Economy’sPerformance

GROSS DOMESTIC PRODUCT

• The total market value of all final goods and services produced within a country in a given year produced by residents (nationals or foreigners) in the economy

Note:• GDP is a monetary measure:

Quantities x prices

Money valuation allows the summing of apples and oranges; money acts as the common

denominator

Gross Domestic Product Measures Total Production

Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time, typically one year.

Measuring Total Production: Gross Domestic Product

GDP Is Measured Using Market Values, Not Quantities

The word value is important in the definition of GDP.

Gross Domestic Product Measures Total Production

Final good or service A good or service purchased by a final user.

Measuring Total Production: Gross Domestic Product

Intermediate good or service A good or service that is an input into another good or service, such as a tire on a truck. NOT ICLUDED IN GDP

GDP Includes Only Current Production

GDP Includes Only the Market Value of Final Goods

GDP includes only production that takes place during the indicated time period.

Calculating GDP

PRODUCTION AND PRICE STATISTICS FOR 2007

(1)PRODUCT

(2)QUANTITY

(3)PRICE PER UNIT

Eye examinations 100 $50.00

Pizzas 80 10.00

Textbooks 20 100.00

Paper 2,000 0.10

PRODUCT(1)

QUANTITY(2)

PRICE PER UNIT(3)

VALUE

Eye examinations 100 $50 $5,000

Pizzas 80 10 800

Textbooks 20 100 2,000

Gross Domestic Product Measures Total Production

Production, Income, and the Circular Flow Diagram

Gross Domestic Product Measures Total Production

Components of GDP

Consumption Spending by households on goods and services, not including spending on new houses.

Personal Consumption Expenditures, or “Consumption”

Investment Spending by firms on new factories, office buildings, machinery, and additions to inventories, and spending by households on new houses.

Gross Private Domestic Investment, or “Investment”

Don’t Let This Happen to YOU!Remember What Economists Mean by Investment

Gross Domestic Product Measures Total Production

Components of GDP

Government purchases Spending by federal, state, and local governments on goods and services.

Government Consumption and Gross Investment, or “Government Purchases”

Transfer payments Payments by the government to individuals for which the government does not receive a new good or service in return.

!!! NOT A PART OF GDP !!!

Gross Domestic Product Measures Total Production

Transfer payments Payments by the government to individuals for which the government does not receive a new good or service in return.

!!! NOT A PART OF GDP !!!

Production, Income, and the Circular Flow Diagram

GDP Excludes Non-production Transactions

These are:1- Purely financial transactions are excluded:1- Purely financial transactions are excluded:

a.a. Public transfer payments, like social security payments, Public transfer payments, like social security payments, welfare payments, and veteran’s payments. These welfare payments, and veteran’s payments. These contribute nothing to current production in return.contribute nothing to current production in return.

b.b. Private transfer payments, like student allowances or Private transfer payments, like student allowances or money given by parents to children. They produce no money given by parents to children. They produce no outputoutput

c.c. The sale of stocks and bonds represent a transfer of The sale of stocks and bonds represent a transfer of existing assets (just swap of papers). Note: the brokers’ existing assets (just swap of papers). Note: the brokers’ fees are included in GDP for services rendered.fees are included in GDP for services rendered.

2 - Secondhand sales are excluded; they do not represent 2 - Secondhand sales are excluded; they do not represent current output. (However, any value added between current output. (However, any value added between purchase and resale is purchase and resale is includedincluded, e.g., used car dealers)., e.g., used car dealers).

To avoid multiple counting

1. Only consider the value of final products. Or

2. Measure and cumulate the value added at each stage of production

Value added = market value of the product – the value of inputs. This is paid as wages, rent, interest and profits.

Example

Suit production

stages of production

sales value of materials or product Value added

0 firm A: sheep ranch 120 120 (=120-0) firm B: wool processor 180 60 (=180-120) firm C: suit manufacturer 220 40 (=220-180) firm D: Clothing wholesaler 270 50 (=270-220) firm E: Retail Clothier 350 80 (=350-270) Total Sales value 1140 Value Added 350

Two ways to calculate GDP

Gross Domestic Product Measures Total Production

Components of GDP

Net exports Exports minus imports.

Net Exports of Goods and Services, or “Net Exports”

An Equation for GDP and Some Actual Values

NXGICY

Gross Domestic Product Measures Total Production

An Equation for GDP and Some Actual Values

Kuwait GDP Sector 2003 2004 2005 2006

Oil & Gas 5797.8 7822.0 12832.8 16214.9

Mining and Quarrying 17.0 22.5 32.4 41.3

Agriculture and Fishing 64.9 70.9 71.1 74.4

Manufacturing of which : 1127.0 1455.9 1712.9 1973.4

Refined Products Industry : 572.4 795.5 970.2 1159.2

Electricity, Gas and Water 299.4 306.9 319.1 336.6

Construction 349.3 401.9 437.1 479.3

Wholesale and Retail Trade 890.2 950.2 1017.8 1088.8

Restaurants and Hotels 174.2 170.5 168.0 171.2

Transport, Storage and Communications 799.9 1048.0 1230.7 1397.4

Financial Instituitions 1171.7 1496.5 2776.6 3813.4

Insurance 64.9 62.1 78.8 97.7

Real Estate 1062.0 1094.8 1208.4 1295.8

Business Services 186.6 227.2 242.3 253.4

Community, Social and Personal Services 2726.4 2950.0 3228.3 3478.7

GDP at Producer's Price 14731.3 18079.4 25356.3 30716.3

Imputed Bank & insurance Service Charges -612.9 -724.2 -1052.1 -1318.1

Imports Duties 135.1 161.5 173.6 174.6

GDP at Purchaser's Price Value 14253.5 17516.7 24477.8 29572.8

Real GDP versus Nominal GDP

Real GDP The value of final goods and services evaluated at base-year prices.

Calculating Real GDP

Nominal GDP The value of final goods and services evaluated at current-year prices.

Solved Problem 7-3Calculating Real GDP

PRODUCT2009

QUANTITY2000

PRICE VALUE

Eye examinations 100 $40 $4,000

Pizzas 80 11 880

Textbooks 20 90 1,800

Real GDP 6680

2000 2009

PRODUCT QUANTITY PRICE Value QUANTITY PRICE Value

Eye examinations 80 $40 3200 100 $50 5000

Pizzas 90 11 990 80 10 800

Textbooks 15 90 1350 20 100 2000

GDP 5540 7800

Real GDP versus Nominal GDP

Comparing Real GDP and Nominal GDP

FIGURE 7-3

Nominal GDP and Real GDP, 1990–2006

Real GDP versus Nominal GDP

Price level A measure of the average prices of goods and services in the economy.

The GDP Deflator

GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

100Nominal GDP

GDP deflatorReal GDP

Nominal GDPReal GDP 100

GDP deflator

Real GDP versus Nominal GDP

FORMULA APPLIED TO 2005 APPLIED TO 2006

GDPDeflator

2005 2006

NOMINAL GDP $12,456 billion $13,247 billion

REAL GDP $11,049 billion $11,415 billion

100GDP Real

GDP Nominal

The GDP Deflator

116100billion $11,415

billion 247,13$

116 1132.7%

113

113100billion $11,049

billion 456,12$

GDP vs GDP per capita

WHICH economy has enjoyed the best economic performance over

the past five years: America's or Japan's? Most people will pick

America. The popular perception is that America's vibrant economy

was sprinting ahead. And it is true that America's average annual real

GDP growth of 2.9% was much faster than Japan's 2.1%. However,

the single best gauge of economic performance is not growth in GDP,

but GDP per person, which is a rough guide to average living

standards. It tells a completely different story.

Source: “Grossly distorted picture” The Economist, March 13th, 2008.

URL: http://www.economist.com/finance/displaystory.cfm?story_id=10852462

GDP vs GDP per capita

Does GDP Measure What We Want It to Measure?

Household production refers to goods and services people produce for themselves.

Shortcomings in GDP as a Measure of Total Production

Household Production

The Underground Economy

Underground economy Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

Does GDP Measure What We Want It to Measure?

Shortcomings of GDP as a Measure of Well-Being

The Value of Leisure Is Not Included in GDP

GDP Is Not Adjusted for Pollution or Other Negative Effects of Production

GDP Is Not Adjusted for Changes in Crime and Other Social Problems

GDP Measures the Size of the Pie but Not How the Pie Is Divided Up

Gross Domestic Product Measures Total Production

Measuring GDP by the Value-Added Method

Value added The market value a firm adds to a product.

Table 7-1

Calculating Value Added

FIRM VALUE OF PRODUCT VALUE ADDED

Cotton Farmer Value of raw cotton = $1 Value added by cotton farmer = 1

Textile Mill Value of raw cotton woven into cotton fabric = $3

Value added by cotton textile mill = ($3 – $1) = 2

Shirt Company Value of cotton fabric made into a shirt = $15

Value added by shirt manufacturer = ($15 –$3) = 12

L.L. Bean Value of shirt for sale on L.L. Bean’s Web site = $35

Value added by L.L. Bean = ($35 – $15) = 20

Total Value Added = $35

Other Measures of Total Production and Total Income

The Division of Income

FIGURE 7-5

The Division of Income

An Inside LOOK Trucking Industry Depends on the Goods—Not Services—Component of GDP

Economic Slowdown Slams Breaks on Trucking Sector

As goods decline as a percentage of GDP, so does the demand for ground-freight transportation services. (The goods and services shares of GDP do not sum to 100 percent because GDP is composed of goods, services, and structures.)

Two Ways to Look at GDP:Spending and Income

• Expenditures Approach: GDP is divided into the categories of buyers in the market; household consumers, businesses, government, and foreign buyers.

• Add up all the spending on final goods and services took place throughout the year. These are:

1. Personal Consumption Expenditures (C):On durable goods (goods lasting 3 years or more), non-durable goods and services.

2. 2. Gross Private Domestic Investment (Ig):

Includes:a. All final purchases of machinery, equipment, and tools by

businesses.

b. All construction (including residential).

c. Changes in business inventory.

• Positive and negative changes in inventories

A. If total output exceeds current sales, inventories build up. When inventory increases, output produced by the economy will be greater than what purchased. We need to calculate unsold output (inventory accumulation) as part of this year’s GDP (add it).

B. If businesses are able to sell more than they currently produce, changes in inventory will be a negative number. when inventory decreases, output produced will be less than what is purchased. Since this inventory depletion had been counted in GDP of previous years, we need to subtract it from this year’s GDP.

• Net Private Domestic Investment (In)

includes only investment in the form of added capital. Each year as current output is being produced, existing capital equipments are wearing out and buildings are deteriorating; this is called depreciation or consumption of fixed capital.

Net investment = gross investment - (consumption of fixed capital) depreciation

Note: :

• If Gross investment > depreciation Positive net investment. the productive capacity of the economy will expand

• If Gross investment < depreciation Negative net investment (disinvestment). The economy’s production capacity will decline.

• If Gross investment = depreciation Net investment equals zero. The nation’s productive capacity will be static.

• Non-investment transactions.

- Transfer of paper assets (stocks and bonds)

- Transfer of tangible assets (e.g., houses)

• These transactions do not create new capital

Definition:

Investment is the creation of new capital assets, that create jobs and income.

3. Government Purchases (of consumption goods and capital goods) – (G)

They include two components:

a) Expenditures for goods and services that the government consumes in providing public services

b) Expenditures on social capital such as schools or highways.

Remember, This entry excludes government transfer payments because they generate no production of any sort.

4 - Net Exports (Xn):

All spending on final goods produced in Kuwait must be included in GDP, whether the purchase is made here or abroad.

These include spending on domestic output by foreigners (Exports X). They also include expenditures by residents on foreign made goods (Imports M).

Instead of adding exports and subtracting imports we only add “net exports”

Xn = X - M

Now adding all things together

GDP = C + Ig + G + Xn(X-M)

0 1 2 3 4 5 6 7 8 9 10

United StatesJapan

GermanyUnited

KingdomFranceChina

ItalyCanadaMexico

SpainBrazilIndia

Korea, Rep.Netherlands

Australia

GLOBAL PERSPECTIVEComparative GDPs in Trillions, 2001

Source: World Bank

Next:

The Income Approach

Kuwait’s GDP

Sector 2003 2004 2005 2006

Oil & Gas 5797.8 7822.0 12832.8 16214.9

Mining and Quarrying 17.0 22.5 32.4 41.3

Agriculture and Fishing 64.9 70.9 71.1 74.4

Manufacturing of which : 1127.0 1455.9 1712.9 1973.4

Refined Products Industry : 572.4 795.5 970.2 1159.2

Electricity, Gas and Water 299.4 306.9 319.1 336.6

Construction 349.3 401.9 437.1 479.3

Wholesale and Retail Trade 890.2 950.2 1017.8 1088.8

Restaurants and Hotels 174.2 170.5 168.0 171.2

Transport, Storage and Communications 799.9 1048.0 1230.7 1397.4

Financial Instituitions 1171.7 1496.5 2776.6 3813.4

Insurance 64.9 62.1 78.8 97.7

Real Estate 1062.0 1094.8 1208.4 1295.8

Business Services 186.6 227.2 242.3 253.4

Community, Social and Personal Services 2726.4 2950.0 3228.3 3478.7

GDP at Producer's Price 14731.3 18079.4 25356.3 30716.3

Imputed Bank & insurance Service Charges -612.9 -724.2 -1052.1 -1318.1

Imports Duties 135.1 161.5 173.6 174.6

GDP at Purchaser's Price Value 14253.5 17516.7 24477.8 29572.8

The Income Approach to GDP

• Demonstrates how the expenditures on final products are allocated to resource suppliers. Items that make up national income are:

1. Compensation of employees includes:• wages, • salaries, • payments made on behalf of workers like social security

and other health and pension plans.

2. Rents: payments for supplying property resources (if adjusted for depreciation it will be the net rent).

3. Interest: payments from private business to suppliers of money capital. It also includes interest the households receive on their savings deposits, CDs (certificates of deposits), and corporate bonds

4. Profits:A. Proprietors’ income: income of incorporated businesses:

sole proprietorships, partnerships, and cooperatives.

A. Corporate profits: After corporate income taxes(1) are paid to government, dividends(2) are distributed to the shareholders, and the remainder is left as undistributed corporate profits(3).

• The sum of the above entries equals national income: all income earned by Kuwaiti-supplied resources, whether here or abroad

From National Income to GDP

National income is all income that flows to nationals, whether resident in the country or abroad. Adjustments required to balance expenditures and income. To get GDP we have to add three items:

1- indirect business taxes:These include general sales taxes, excise taxes, business property taxes and customs duties. (the seller treats these taxes as a cost of production, hence, they are part of the market value of output, but not of income).

2. Depreciation/Consumption of Fixed Capital: The firm also regards the decline of its capital stock as a cost of production. In addition to the depreciation of private capital, depreciation public capital (government buildings, port facilities, etc.), must be included in this entry.

• This is a cost of production and should be included in the gross value of output. Since this does add to income it must be added to national income to balance with the economy’s expenditures

3. Net foreign factor income:

National income measures the income of Kuwaitis both here and abroad. To make this final adjustment, the income of foreign nationals must be added and Kuwaiti income earned abroad must be subtracted. Sometimes this entry is a negative number.

+

+

+

++

++

GROSS DOMESTIC PRODUCT

Consumptionby Households

Investmentby Businesses

GovernmentPurchases

Expendituresby Foreigners

Expenditures Approach Income ApproachWages

Rents

Interest

Profits

StatisticalAdjustments

= =GDP

OTHER NATIONAL ACCOUNTS (USA EXAMPLE)

•Gross Domestic Product (GDP) $10,446Consumption of fixed capital -1,393

•Net Domestic Product (NDP) $9,053Net foreign factor income earned in the U.S. - 10

Indirect business taxes - 695•National Income (NI) $8,348

Social security contributions -748Corporate income taxes -213 Undistributed corporate profits -141Transfer payments +1,683

•Personal Income (PI) $8,929Personal Taxes -1,113

•Disposable Income (DI) $7,816

U.S. GDP, NDP, NI, PI, & DI, 2002

Definitions: Definitions:

A. A. Net domestic product (NDP) is equal to GDP minus depreciation allowance (consumption of fixed capital).

B. National income (NI) is income earned by Kuwaiti‑owned resources here or abroad. Adjust NDP by subtracting indirect business taxes and adding net Kuwaiti income earned abroad. (Note: This may be a negative number if foreigners earned more in Kuwait than Kuwaiti resources earned abroad.)

C. Personal income (PI) is income received by households. To calculate, take NI minus payroll taxes (social security contributions), minus corporate profits taxes, minus undistributed corporate profits, and add transfer payments.

D. Disposable income (DI) is personal income less personal taxes.

Nominal versus Real GDP

• Nominal GDP is the market value of all final goods and services produced in a year. This creates problems when we compare GDP over time.

• If GDP increases, this may be due to rises in quantities or in prices or both. But it is only the quantity of goods we produce that affects our standards of living not the price.

• To measure changes in the quantity of output, we need To measure changes in the quantity of output, we need a a yardstick that stays the same size.yardstick that stays the same size.

• To make comparisons of real output, a K.D. must keep the To make comparisons of real output, a K.D. must keep the same purchasing power over time.same purchasing power over time.

• Unadjusted (nominal) GDP: is based on current pricesUnadjusted (nominal) GDP: is based on current prices

• To overcome this problem we deflate GDP when prices rise, or inflate GDP when prices fall. Adjusted (real) GDP is deflated or inflated to reflect changes in prices.

Adjustment process in one product economy.

Valid comparisons cannot be made with nominal GDP alone, since both prices and quantities are subject to change. Some methods to separate the two effects must be devised..

Adjustment Process: • First Method: GDP Price Index: first determine a

price index, then adjust the nominal GDP figures by dividing by this price index

• Price index = (price of market basket in a specific year/ price of the same basket in base year) x 100.

• Real GDP = (Nominal GDP/Price index) x 100

Price Index: is a measure of the price of a specified collection of goods and services called a “market basket” in a given year (e.g. current year) compared to the price of an identical collection of goods and services in a reference (base) year.

NOMINAL GDP vs. REAL GDP: GDPNOMINAL GDP vs. REAL GDP: GDP Output of PizzaOutput of Pizza

12345

578

1011

$ 1020253028

100200250

--

$ 50140200

--

$ 507080

--

(2)PricePizza

Per Unit

(1)Units ofOutput

Of PizzaYear

(3)Price Index

Year 1 =100

(4)Unadjusted,or Nominal,

GDP,(1)x(2)

(5)Adjusted,Or Real,

GDP

Note: Note:

The market basket is composed of The market basket is composed of pizzas pizzas onlyonly

Year 1 is the base yearYear 1 is the base year

Real GDP can be calculated by multiplying units of output by base year pricesReal GDP can be calculated by multiplying units of output by base year prices

Adjustment Process: An alternative method

• Multiply current quantities of goods and services by prices of the base year to calculate real GDP

• Multiply current quantities of goods and services by current year prices to calculate nominal GDP

• Calculate the price index (Multiply by 100 to put it in standard index form) by:

• Price index = (nominal GDP/real GDP) x 100

• Consumer Price Index

Reports the price of a market basket of some consumer goods and services purchased by a typical urban consumer

• CPI = (price of a market basket in any given year / price of the same market basket in base year) x 100

SHORTCOMINGS OF GDP

• Non-market Transactions

GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services, parental child care, volunteer efforts, home improvement projects), e.g., the services of a carpenter who repairs his own home are not included in GDP.

One exception: output that farmers consume themselves is estimated and added.

• Improved Product Quality:

Over time product quality improves though prices may be the same. Quality affects our welfare. GDP doesn’t measure improvements in product quality

• Leisure (GDP ignores leisure value):

We spend more leisure time. GDP doesn’t measure improved living conditions as a result of more leisure. This affects our welfare, but this is not reflected in GDP.

• Composition and Distribution of Output: GDP makes no value adjustments for changes in the composition of output or the distribution of income.

Nominal GDP simply adds the dollar value of what is produced; it makes no difference if the products are guns or food.

GDP figures do not provide information about how the income is distributed.

• The Underground Economy:Illegal activities are not counted in GDP (estimated to be around 8% of U.S. GDP).

Legal economic activity may also be part of the “underground,” usually in an effort to avoid taxation

• GDP and the environment:The harmful effects of pollution are not deducted from GDP (e.g., oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view).

Note that GDP does include payments made for cleaning up oil spills and the cost of health care for cancer victims.

0 5 10 15 20 25 30Greece

Italy

Spain

Portugal

Belgium

Sweden

Germany

France

Holland

United

Kingdom

Japan

United States

Switzerland

GLOBAL PERSPECTIVEThe Underground Economy as a Percent of GDP

Source: The Journal of Economic Literature, 2000